Who wants to close the backdoor Roth?
We know from Hitchhiker’s Guide to the Galaxy that mankind is only the third most intelligent species on Earth. This fact becomes most obvious when you consider the United States tax code. Historically, the periodic “improvements” we make to it typically add unnecessary complexity and have the opposite of the intended effect – yet we keep improving it with new tax reforms every day!
The following image is of a letter that redditor /u/MrHoova received from Senator Ron Wyden in response to a question regarding one such recent tax reform proposal. Silently introduced while most of the country was focused on proving yet again the veracity of Godwin’s law,1 the Retirement Improvements and Savings Enhancements (RISE) Act of 2016 proposed drastic changes relating to the plans of FIRE hopefuls. I’ll give you a hint on my position: I find it to be very clear that Senator Wyden did not consult either of the more intelligent species on Earth when he (or his staff) wrote the proposal draft.
Committee proposals frequently die unenacted or undergo significant change before they are considered by the full House or Senate, and the RISE Act was no exception. The 114th Congress wound up without the Act leaving the Senate Finance Committee, leaving it to the dustbin of history. But it’s unlikely to be gone for long – Senator Wyden introduced largely the same bill just one year earlier, and it’s an idea that’s periodically revisited by lawmakers. It’s typically revisited when they’re prodded by media pressure about the tax-advantaged accounts of the mega-rich. Such as, say, the IRA of 1950s sitcom dad Mitt Romney. So the reform’s return is a matter of when, not if.
The Bad: Title II of the RISE Act
Title II of the RISE Act would have, among other things, eliminated the backdoor Roth IRA contribution as part of a plan to close some tax loopholes exercised by the mega-rich.2 It’s Title II that I want all Vigilantes to be aware of. It is explicitly intended to get extra tax revenue from the people who make up the higher-balance end of this table:
The idea is simple: We need tax revenue; they can afford it. At this point, a lot of you are surely on board!
Don’t be. While I suspect Title II would be scaled back to some kind of conversion limitation rather than the proposed complete elimination of conversions before it could be passed, the proposal was frightening. It means nothing to most people, who will never use the conversion. But it means something to people who pursue FIRE. To people who save a lot of their earned income in a traditional IRA when they reach that point on the Millionaire Maker Flow Chart of Freedom. To people who manage to live without dipping into their IRA today. People like The Vigilante, who lives on a bit more than minimum wage expenses today in the hope that, in the future, the money I’ve diligently saved will be accessible. And people like those you, the readers of this blog!3
But what is the backdoor Roth?
The backdoor Roth works, mechanically, as Senator Ron Wyden described: You contribute a non-deductible sum to a traditional IRA4 and then move it to a Roth IRA shortly thereafter. This is money that then can grow, like other IRA funds, with no capital gains tax. And, five years or more in the future, you can withdraw from the Roth IRA the amount you contributed. Earnings on that account cannot be withdrawn without paying income tax at the rate you’re paying that year. And, if you’re under an arbitrary age set by the apparently omniscient IRS, you’ll pay a 10% penalty for early withdrawal of earnings. (Just like you do for the withdrawal of any traditional IRA funds outside of certain exceptions, which is why most people use the conversion in the first place.)
But that’s where the accuracy of Senator Wyden’s letter ends. The backdoor Roth is not a “scheme,” as the good Senator suggests: It is, for the vast majority of IRA owners, merely a method of delayed gratification. It is saying to yourself “I don’t need this money today, so I will pay the rest of my taxes on it and use it tomorrow (or, realistically, five or more years from now), instead.” You don’t avoid your “fair share,” you just pay most of it in income tax now and a bit of it later, and you avoid a 10% penalty to access your own money – on which you already paid taxes – in the process. You crooked Scrooge, you!
I realize few people have sympathy for millionaires. And with regard to this particular legislation, rightfully so. The RISE Act was not a doomsday scenario for early retirement, and many of its merits and demerits are legitimately up for debate.
But if this kind of legislation gains further traction in the future, it will become national news. And I beg you, dear Vigilantes in Training:5 Please don’t blindly support it just because they will call the backdoor Roth a “tax loophole” for the “mega rich!” This is precisely the public relations strategy that will help politicians eliminate one of the few tax strategies that exists to actually help the lower and middles classes become wealthy over time. And this public relations strategy will be used, mark my cynical and skeptical words.
What’s more: The RISE Act wouldn’t work.
The mega-rich won’t be dramatically hurt from capital gains taxes on money that they may have to keep in other vehicles instead of a Roth IRA. They won’t hurt from a 10% penalty on withdrawals, since someone that wealthy rarely needs to make a withdrawal from this account. They also won’t be hurt by the proposal to disallow contributions to IRAs worth more than $5 million, because hardly any contributions are made at that point, anyway.
Federal tax revenue won’t notice the difference, because we’re talking about mere millions in additional tax revenue – not billions or trillions. Now, I don’t have a study to verify that claim, because the bill didn’t make it far enough for anyone to bother. But consider this: The bill’s main supporter, Senator Wyden, estimates the tax subsidy of all IRAs to add up to only about $1 trillion in five years. According to the GAO Analysis of IRS data above, only about 0.3% of IRAs are worth more than $2,000,000.6 The majority of subsidized money – about 78.1% – is in accounts with $1,000,000 or less.7 I wouldn’t expect to see trillions in revenue each year from small additional taxes and penalties on withdrawals. I also don’t see how it’s mathematically possible for anything more than several million to be generated from capital gains on mere hundreds of millions of dollars in investments that would otherwise have been in IRAs if not for the RISE Act.
I’m all for closing a budget deficit through baby steps, but let’s close the useless wastes in our spending rather than targeting an everyman wealth-building strategy, shall we? Look at it from the perspective of household spending: If you’re cutting spending in your own household, you don’t cut fruits and vegetables before BMWs and yachts, right? Or maybe you would – in which case, welcome, Senators and Congressmen! Thanks for reading!
What the RISE Act would do.
Contrast the mega-rich to your friend, neighbor, coworker, or Vigilante mentor who saved a lot of money to try to actually have something to live on in the future. The latter group would hurt. The RISE Act would make it just a little harder – about 10% harder, give or take8 – to become wealthy on W-2 wages and wise financial planning alone. Suddenly, these folks who actually withdraw their contributions to live (again, not the mega-rich!) will have to pay 10% penalties on early withdrawals from their IRAs. And many of us will pay more capital gains taxes throughout the years, due to decreased capacity to make use of our IRAs for tax savings.
This won’t bring Mitt Romney down to your level,9 and it won’t make him “pay his fair share.” It just makes it harder for you to call yourself a millionaire someday. It’s a dramatic tax increase on the semi-wealthy and on the poor who could potentially become wealthy; it is not a dramatic tax on the mega-rich.10
So it is with the best laid plans of men.
But why should you care if it didn’t pass?
This is the real question, and I’m glad you asked!
If nothing else, this proposed legislation provides a simple warning to those currently saving to FIRE: It highlights that tax laws can ( and will) change before you reach the age for penalty-free distributions. That account you’re maxing out and intend to use for a certain purpose may be unexpectedly more difficult to access in the future. It also may be easier. Or you may find that you need to save more to account for an unavoidable 10% penalty – or maybe for an unpredictably higher future penalty. Or there may be a new account that allows for tax-free growth and penalty-free distributions for all. (It will probably come with a free unicorn, too.)
Does all of this mean that FIRE is an unobtainable dream, or too big of a risk? Of course not! It just means that you may have to work an extra year or two to accommodate poorly thought-out legislation or regulation.11 For the risk-averse among us – which, let’s be honest, is most people reading this blog – that’s a cushion we were planning on building, anyway!
The greater concern, to a Vigilante, is the susceptibility of all of us to taking action based on misleading public relations campaigns. We all need a Bullshit Detector, and this proposal is a prime example of why. The success of this proposal would result not in a major shift of wealth from Mitt Romney to the poor. Rather, it would result in a tiny shift in wealth from Mitt Romney, and a medium-sized shift in wealth (particularly relative to the amount of wealth per person that we’re talking about) from millions of lower-middle-class and upper-middle-class Americans to the federal government. Most likely to fund something else of questionable origins – perhaps a wall?12
But despite that truth, the proposal will be sold to the public as the closing of a loophole and as a major shift in wealth from “mega-rich cheaters” to the innocent everyman. It’s a guilt by association mistake at best; it’s an outright lie at worst. “Loophole,” as it relates to tax, is a buzzword. And, while it is a real thing and is a real problem in an incredibly over-convoluted tax code, the word is usually more useful as a signal for incoming propaganda. “Loophole” should set off your Bullshit Detector. Hard.
Always be careful with buzzwords, always be aware of changing circumstances, and always be aware that the best laid plans of men – whether tax planners or tax savers – may fail. Remember our place; we don’t know it all. As the famous line from the Hitchhiker’s Guide goes:
Slartibartfast: [talking about the Earth] Best laid plans of mice.
Arthur: And men.
Arthur: Best laid plans of mice and men.
Slartibartfast: Oh. No, I don’t think men had much to do with it.
- The law of the internet which states that, as an online discussion grows longer, the probability of one person making a comparison of an opponent to Adolf Hitler approaches 1.
- The RISE Act as a whole was not all bad. Title I would make the Saver’s Credit for contributions made by low-income taxpayers refundable directly to a tax-advantaged account so that those savers without any tax liability could receive the benefit of their qualifying contributions as a sort of government matching contribution. As redistributions of wealth go, I love that idea! The Act would also allow IRA contributions after age 70.5, and would raise the age for required minimum distributions incrementally to 73 years of age in 2028 and raise it thereafter with life expectancy. There are also proposed optional 401(k) matching contributions for employers who want to assist employees who make student loan payments rather than contributing to their 401(k)s. And finally, there are some anti-abuse rules targeting largely the same kind of activity discussed by Biglaw Investor in his post about $100,000,000 IRAs. These are all ideas that sound tempting enough in theory that it may be worth considering the costs and benefits and potential questions of individual and taxpayer rights that they raise. Read more about them in the single-page Discussion Draft or just read the text of the proposal itself.
- I’m still unclear on who exactly you are, but thanks for coming! And I apologize for the low quality of content!
- Meaning you’ve paid your taxes on this money, if you’re a regular Joe working for W-2 wages!
- Wait, do I have to beg? You’re in training, so…can’t I order it? I don’t know how to run a cult yet.
- Total number of taxpayers with >$2M divided by the total number of taxpayers in all rows combined.
- Estimated total IRA fair market value balance in accounts worth <$1M divided by the estimated total IRA fair market value of all rows combined.
- Completely mathematically inaccurate.
- Which is an utterly confusing goal to me, anyway. Seems like something way outside my Circle of Control and not worth the worry.
- It is potentially a tax on the children of the mega-rich, depending on tax consequences after death. But I have not researched that fully, so I’ll keep my musings on that topic to myself.
- I realize “poorly thought-out” is redundant before “legislation or regulation” in our tax laws, but for the benefit of the delicate sensibilities of Normies, I’ll pretend that there’s another kind.
- Like, around the Massachusetts area, to keep the New England Patriots away. #NotMySuperbowlChamps